chapter measuring the cost of living 16. the consumer price index consumer price index (cpi) –...
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Chapter
Measuring the Cost of Living
16
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The Consumer Price Index
• Consumer price index (CPI)– Measure of the overall cost of goods &
services – Bought by a typical consumer
• How the consumer price index is calculated1.Fix the basket2.Find the prices3.Compute the basket’s cost
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The Consumer Price Index
• How the consumer price index is calculated4. Chose a base year and compute the CPI
• Price of basket of goods & services in current year• Divided by price of basket in base year• Times 100
5. Compute the inflation rate• Percentage change in the price index from the
preceding period
3
1001 year in CPI
1 year in CPI-2 year in CPI2 year in rate Inflation
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Table
Calculating the CPI and the inflation rate: an example
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4
Step 1: Survey consumers to determine a fixed basket of goods
Basket = 4 hot dogs, 2 hamburgers
Step 2: Find the price of each good in each year
Year Price of hot dogs Price of hamburgers
200820092010
$123
$234
Step 3: Compute the cost of the basket of goods in each year
200820092010
($1 per hot dog × 4 hot dogs) + ($2 per hamburger × 2 hamburgers) = $8 per basket($2 per hot dog × 4 hot dogs) + ($3 per hamburger × 2 hamburgers) = $14 per basket($3 per hot dog × 4 hot dogs) + ($4 per hamburger × 2 hamburgers) = $20 per basket
Step 4: Choose one year as a base year (2008) and compute the CPI in each year
200820092010
($8 / $8) × 100 = 100($14 / $8) × 100 = 175($20 / $8) × 100 = 250
Step 5: Use the consumer price index to compute the inflation rate from previous year
20092010
(175 – 100) / 100 × 100 = 75%(250 – 175) / 175 × 100 = 43%
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Figure
The typical basket of goods and services
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5
This figure shows how the typical consumer divides spending among various categories of goods and services. The Bureau of Labor Statistics calls each percentage the “relative importance” of the category.
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The Consumer Price Index
• Problems in measuring the cost of living– Substitution bias– Introduction of new goods– Unmeasured quality change
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MEASURING THE COST OF LIVING 7
Correcting Variables for Inflation:Comparing Dollar Figures from Different Times
• Inflation makes it harder to compare dollar amounts from different times.
• Example: the minimum wage– $1.15 in Dec 1964– $5.85 in Dec 2007
• Did min wage have more purchasing power in Dec 1964 or Dec 2007?
• To compare, use CPI to convert 1964 figure into “today’s dollars”…
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MEASURING THE COST OF LIVING 8
• In our example, – year T = 12/1964, “today” = 12/2007– Min wage = $1.15 in year T– CPI = 31.3 in year T, CPI = 211.7 today
Correcting Variables for Inflation:Comparing Dollar Figures from Different TimesAmount in today’s
dollars
Amount in year T dollars
Price level today
Price level in year T= x
$7.78 $1.15211.731.3
= xThe minimum wage in 1964 was $7.78
in today’s (2007) dollars.
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MEASURING THE COST OF LIVING 9
Correcting Variables for Inflation:Comparing Dollar Figures from Different Times
• Researchers, business analysts and policymakers often use this technique to convert a time series of current-dollar (nominal) figures into constant-dollar (real) figures.
• They can then see how a variable has changed over time after correcting for inflation.
• Example: the minimum wage, from Jan 1950 to Dec 2007…
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The U.S. Minimum Wage in Current Dollarsand Today’s Dollars, 1950-2007
$ pe
r ho
ur
$0
$1
$2
$3
$4
$5
$6
$7
$8
$9
1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005
current dollars
2007 dollars
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Annual tuition and fees, average of all public four-year colleges & universities in the U.S.
– 1986-87: $1,414 (1986 CPI = 109.6)– 2006-07: $5,834 (2006 CPI = 203.8)
After adjusting for inflation, did students pay more for college in 1986 or in 2006? Convert the 1986 figure to 2006 dollars and compare.
A C T I V E L E A R N I N G A C T I V E L E A R N I N G 44
Converting to “today’s dollars”Converting to “today’s dollars”
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A C T I V E L E A R N I N G A C T I V E L E A R N I N G 44
AnswersAnswers
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Solution
Convert 1986 figure into “today’s dollars”
$1,414 x (203.8/109.6) = $2,629
Even after correcting for inflation, tuition and fees were much lower in 1986 than in 2006!
Annual tuition and fees, average of all public four-year colleges & universities in the U.S.
– 1986-87: $1,414 (1986 CPI = 109.6)– 2006-07: $5,834 (2006 CPI = 203.8)
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MEASURING THE COST OF LIVING 13
Correcting Variables for Inflation:Indexation
For example, the increase in the CPI automatically determines– the COLA in many multi-year labor contracts– the adjustments in Social Security payments and
federal income tax brackets
A dollar amount is A dollar amount is indexedindexed for inflation for inflation if it is automatically corrected for inflation if it is automatically corrected for inflation
by law or in a contract.by law or in a contract.
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MEASURING THE COST OF LIVING 14
Correcting Variables for Inflation:Real vs. Nominal Interest Rates
The nominal interest rate: – the interest rate not corrected for inflation– the rate of growth in the dollar value of a
deposit or debt
The real interest rate:– corrected for inflation– the rate of growth in the purchasing power of a
deposit or debt
Real interest rate = (nominal interest rate) – (inflation rate)
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MEASURING THE COST OF LIVING 15
Correcting Variables for Inflation:Real vs. Nominal Interest Rates
Example:– Deposit $1,000 for one year.
– Nominal interest rate is 9%.
– During that year, inflation is 3.5%.
– Real interest rate = Nominal interest rate – Inflation= 9.0% – 3.5% = 5.5%
– The purchasing power of the $1000 deposit has grown 5.5%.
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MEASURING THE COST OF LIVING 16
Real and Nominal Interest Rates in the U.S.,1950-2007
-10
-5
0
5
10
15
1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005
Inte
rest
Rat
es
(per
cen
t p
er y
ear)
Nominal interest rate Real interest rate
-10
-5
0
5
10
15
1950 1955 1960 1965 1970 1975 1980 1985 1990 1995 2000 2005
Inte
rest
Rat
es
(per
cen
t p
er y
ear)
Nominal interest rate Real interest rate